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London Stock Exchange (LSE) is a major player among stock exchange operators. After losing out on an earlier deal-making attempt, LSE is betting on two other recent acquisitions, in indexes and clearing, to help fuel growth. We see LSE as poised to remain a competitive force in the continuously evolving exchange industry.
Capital markets are at the heart of LSE's business and this segment recently made up 24% of the company’s total revenue, including net treasury income and adjusted for the LCH. Clearnet stake acquisition. These businesses include cash equities trading in the U.K. and Italy, derivatives and fixed-income trading and company listing fees. We expect that LSE will see further revenue gains in capital markets, helped by a recovering European economy. But the exchange industry remains competitive and we think investors should expect LSE to remain in a pitched battle for market share against rivals such as BATS Chi-X Europe.
Separately, we see net treasury income from LSE's CC&G business - interest earned on cash and securities posted as margin and default funds - as a volatile source of earnings. In recent years, this line had jumped, but now is receding amid anticipated regulatory changes. Our expectation is that growth in this business will be more muted going forward, lessening its chances to lead to sharp upside earnings surprises.
LSE's information services segment, which contributes about 27% of total revenue, includes market data fees and revenue from the FTSE indexes. We think this segment should continue to see steady growth, helped by market participants' continuing need for market data and appetite for index-based offerings. Other business segments include post-trade services, such as clearing, settlement, and custody services, and technology. Furthermore, we expect that an important part of management’s attention will be focused on integrating LSE’s May 2013 acquisition of a majority stake in clearing-services provider LCH. Clearnet. We think this operation has interesting prospects, but we do have some concerns about recent customer losses.
We are moving our fair value estimate for LSE to £13 per share from £10 per share. This would value the company at about 13 times its estimated fiscal 2014 adjusted earnings. Key drivers of our new valuation include our upwardly revised expectations for revenue, which now we see growing at a compounded annual rate of about 9.5% through the 2018 fiscal year. In turn, this reflects our more optimistic views for eventually higher revenue in business lines such as capital markets, as well as the inclusion of the LCH. Clearnet acquisition.
In a bullish scenario, we think a stronger European economic recovery and improved trading conditions can help total revenue achieve an annual growth rate of about 14%. However, we think the shares may be worth £8 in more bearish conditions - assuming there was a return to economic weakness in Europe, and even tougher competition for trading market share.
In our view, LSE possesses a slim competitive advantage. The company benefits from scale, which should allow it to profit from rising trading activity without a similar escalation in costs. Unique products, such as those in the FTSE stable - which includes the FTSE 100 index, a popular tracker of market performance - also help.
We think this advantage is stable. We are not bracing for a dramatic decline in the company's equities market share, though competitive pressures remain and we will keep monitoring the environment.
Among the most salient risks to LSE's earnings are slowdowns in trading activity. These could be caused by economic and financial turmoil in Europe, which could lead to volatility-inspired trading but also can spook investors. The company's recent deals - for FTSE and a majority stake in LCH. Clearnet - carry execution risk and, if M&A benefits don't materialize, could dent shareowner value. Competitive risks remain keen as well, from players such as BATS Chi-X in European trading, which could steal business from LSE and hurt margins. Lastly, regulatory risks also exist, such as potential damage from financial transaction taxes.
We do not have significant concerns about LSE's financial health at this time. We would generally expect the dividend to grow with the company's earnings over time and we see stock repurchases as being less likely.
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